Trade bodies urge ESMA to clarify EMIR fragmentation stance

Banking lobby groups are warning European policy
makers that ambiguities in the drafting of new swaps rules risk may trigger monopolistic
behaviour from trading venues and clearers.

The British Bankers Association, Association for
Financial Markets in Europe, International Swaps and Derivatives Association
and Italian banking trade body Assosim all raised concerns in a consultation
held by the European Securities and Markets Authority (ESMA) which ended 5
August.

ESMA was seeking views on technical standards related
to the European market infrastructure regulation (EMIR), the new rules for many
derivatives currently traded bilaterally to move on exchange, clear centrally
and be reported to newly-created data repositories.

The groups were particularly concerned by the possible
unintended consequences of article 8.4 of EMIR, a clause which requires central
counterparties (CCPs) and trading venues to grant access to each other only
when “access would not require interoperability or threaten the smooth and
orderly functioning of markets in particular due to liquidity fragmentation”.

The bodies argued that while 8.4 seemed to cast doubt
on the benefits of liquidity fragmentation, they believed some fragmentation can
facilitate competition to the benefit of the market. The groups warned that if
a specific derivative contract could only be cleared by one CCP, anticompetitive
behaviour in clearing costs could arise.

If, for example, a CCP owned by a trading venue only
chose to clear swaps traded on its associated market, other markets would have
to establish separate links with other clearing houses.

This would subsequently require market participants to
have two pools of open interest for the same product, leading to major cost
inefficiencies. The issue has already affected London Stock Exchange-owned
multilateral trading facility (MTF) Turquoise, which was prohibited from sharing
open interest in FTSE 100 options with NYSE Liffe, the dominant derivatives
market for those products.

“We believe that it should be possible for two parties
to trade the same product and agree in advance which CCP they will use to clear
the transaction and that new parties should not be denied access to a CCP (and
the same margin pool) that already clears an existing product,” read a joint submission
from the trade bodies.

In
need of redraft

The lobby groups urged ESMA to redraft article 8.4 so
that it meets ESMA’s stated objectives in relation to fragmentation and
interoperability more clearly.

Other market participants have pointed out that
fragmentation concerns would only arise if the owners of indices on which
popular equity derivatives are based do not let other markets trade the same
index-based instruments. This could force markets to replicate popular
instruments based on different benchmarks and create a lack of fungibility
between products that are essentially the same but traded on different markets.

In addition to its apparent confusion over fragmentation,
other industry observers have noted ESMA’s silence on the ability of markets to
route trades through different CCPs.

“ESMA only looked at the
ability of CCPs to access trading venues, rather than the other half of the
EMIR article which addresses fair and open venue access for sending matched
trades into CCPs,” said Alex McDonald, CEO of the interdealer broker trade body
the Wholesale Markets’ Brokers Association. "There are still a number of ways in which
vertically-owned market infrastructures can make it economically or
technologically more difficult to novate trades executed in outside venues
relative to those done within the silo and it is a concern that ESMA has not
ensured that access is consulted upon.”

There also appears to be a bias towards regulated
markets in the ESMA paper.

McDonald said the ESMA consultation paper uses a
definition of OTC derivatives from EMIR, which states an OTC instrument is
everything traded away from a regulated market. Such a definition would not
include trades done on an MTF or an organised trading facility (OTF).

The paper suggests everything classed as an OTC
derivative would be subject to more onerous risk requirements than those traded
on regulated markets.

“This seems to put in a higher
cost of margin barrier that makes it more beneficial to trade on an exchange,
compared to an OTF or MTF,” said McDonald. “The biannual Bank for International
Settlements data underline that OTC markets are typically much deeper and more
liquid than the exchange, but in any case, these types of requirements should
be aligned to the IOSCO principals of a level playing field and beyond those be
left to a CCP’s risk committee to decide.”

The ESMA paper
also included a framework for deciding when swaps should be deemed eligible for
clearing, risk mitigation requirements for OTC derivatives that are not
centrally cleared, and organisational conduct of business and prudential
requirements for central counterparties.

After receiving the industry feedback, ESMA will now
have until 20 September to finalise the technical standards and deliver them to
the European Commission for approval, ahead of the expected implementation of
EMIR at the start of next year.